Oil divides opinion among value-seeking investors

The rout in commodities has continued into 2016 with the plunging price of oil a particular concern, but could a recovery be on the horizon?

3 February 2016

Investment Communications Team

Investment Communications Team

Commodity capitulation

The start of 2016 has seen little respite for commodity prices and equity markets. Investor sentiment remains downbeat and dominated by familiar themes:

China growth.

Geopolitical tensions.

US dollar strength.

Interest rate rises.

Increased market volatility.

Despite the tumultuous start to the year, which saw the oil price fall below $30 a barrel to its lowest level in more than a decade and copper prices slide to a near six-year low, some investors expect a rebound in commodities, in particular oil.

Many investors are anticipating a near 75% rally in the price of oil in 2016. The latest Reuters poll revealed the average 2016 price for benchmark North Sea Brent crude was forecast at $52.52 a barrel.

Schroders’ own poll found that 51% of respondents would prefer to invest in oil above any other commodity.

Why oil and why the optimism?

Value

Oil prices are now hovering around 2004 levels and analysts and fund managers have been arguing for some time that the rout has been overdone.

“Financial markets have been known to overreact in the past, and it's not a stretch to suggest that they may be reacting very strongly to rather small bits of evidence in an environment of heightened volatility and risk aversion,” Obstfeld said at a recent press conference.

Supply

Oversupply is thought to be the main issue. A recent Bloomberg poll found that 72% of respondents thought the oil slide reflects increased supply rather than slumping demand.

James Barrineau, Schroders Co-Head of Emerging Markets Debt Relative, is in agreement. He said we could be on the cusp of supply restraint, but prices might have to fall further first.

“Prices might dip into the $20s, but this will simply make the cash costs of an even larger amount of production uneconomical and speed the supply-demand adjustment,” Barrineau said.

Growth

Quite rightly there has been some concern over the slowdown in China. From around 14% GDP growth nearly a decade ago, the country’s economy slowed to around 7% in 2015. Although demand is unlikely to be as strong as the country changes to a less energy-intensive service-driven economy, China is still growing at a rate of around 7%.

Green shoots

Signs of an imminent recovery in oil, however, remain few and far between. But Malcom Melville, Wealth Preservation Manager at Schroders, has been hunting for differentiation within commodities for clues.

He noted that in 2011 agricultural commodities peaked in March followed by metals in April and oil in May. Over the last few months, some agricultural prices have started to stabilise while metals and energy have continued to fall.

Melville said that could be a sign that we are nearing a nadir for commodities, although it can’t be guaranteed.

“Commodities have come a long way over the last five years. Tentative signs are emerging the “out- of-fashion” phase (of the sentiment cycle) may be reaching its conclusion. Perhaps the mindset should be to revisit the asset class,” Melville said.

That slither of hope could be music to the ears of oil investors waiting for a recovery. In another Schroders Twitter poll, respondents said they expected the oil price rally to between $35 and $50 by the end of 2016.

Four arguments for investing in oil

Value play with energy prices at their lowest in nearly 12 years.

Sentiment is too downbeat and could turn.

Costs could force producers to cut supplies.

Cold weather in early 2016 and rising global growth could spike demand.

Hope over expectation?

In the short-term the odds appear stacked against a rebound in oil. The International Energy Agency (IEA) warned that there could be further weakness in the oil price over the coming year, and the oil supply could exceed demand in the first-half of 2016.

US v OPEC

There seems to be little sign of a let-up in the blink-first supply battle between OPEC and the shale producers in the US.

Schroders Chief Economist Keith Wade said that the market has been surprised by the resilience shown by the US shale gas producers and their ability to operate at lower price levels.

But he warned that Saudi Arabia, which is currently pulling the strings in the energy market, appears to be preparing for a longer conflict.

“We know from the fact Saudi Arabia is selling reserves, issuing bonds and planning to sell some of its assets it is building up a war chest for a long fight... To me, the oil price could remain much lower for longer,” Wade said at January’s Schroders Live event.

China

Falling energy prices is not a new phenomenon. Since hitting $141.94 per barrel in April 2011, the energy price, as measured by the World Bank Commodity -The Pink Sheet (WBC), has slumped around 80%.

But the ongoing concern over the state of China’s economy has exacerbated the downbeat sentiment surrounding oil.

The road ahead

The road to redemption for oil, and commodities in general, remains paved with potholes, but for optimistic investors with a long-term view perhaps the downbeat sentiment is beginning to bottom-out, creating potential value opportunities for investors.

Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested. All investments involve risks including the risk of possible loss of principal.

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